Crypto Analysis Case Study - ‘Three Arrows Capital’: PART I

By Rodrigo Zepeda, CEO, Storm-7 Consulting

Introduction

By now, the whole crypto world seems to have heard about the crypto hedge fund ‘Three Arrows Capital’ (3AC) filing for bankruptcy in the United States (US). According to the latest reports, the founders of 3AC, Mr Kyle Livingston Davies and Mr Su Zhu have now been reported as missing, in hiding, or on the run. Although, to be honest, I am not quite sure if being on the run from liquidators holds the same type of “street cred” nowadays as being on the run from the police, or even the ‘FBI’ (Federal Bureau of Investigation).

Who knows, perhaps now that Davies and Zhu have made it a “thing” it may catch on in crypto circles, like, ‘Alex Mashinsky (Celsius CEO) has done a 3AC’ (meaning he is on the run from the big bad crypto liquidators). That being said, from the outset I would say that the difficulty with many of the cursory news stories currently circulating in the media, is that they tend to only provide snippets of information regarding 3AC operations, or cursory analyses of 3AC’s collapse. I am not at all surprised. This is because putting together all the different parts to this rather intricate and complex crypto puzzle is exceedingly difficult to say the least.

To do so, we need to legally analyse the liquidator’s case against 3AC in the British Virgin Islands (BVI) under BVI law, we need to legally analyse the bankruptcy filing involving 3AC in the US under US law, and we need to analyse the legal and regulatory framework applicable to 3AC in Singapore. In addition, we need to analyse from crypto investment and operational perspectives, the wide range of crypto investments historically made by 3AC, any relevant moderating crypto market trends and developments, as well as investment strategies adopted by 3AC. This type of extensive multijurisdictional legal, financial, and investment analysis does not usually fall within the repertoire of crypto media reporters.

Consequently, to make it easy for everyone, I have decided to create this Crypto Analysis Case Study spread across multiple blogs that will seek to do all this work on behalf of readers. It will aim to comprehensively analyse and collate all available information on the 3AC collapse, whilst also adding explanatory and interpretative commentary and crypto investment insights throughout. It will seek to use the collapse of 3AC as a legal, practical, and operational case study to illustrate a range of crypto investment and management issues and risks for readers.

In doing so, it is hoped the Case Study will provide readers with a more sophisticated understanding of the latest crypto hedge fund investments and strategies, and the attendant risks. In this first blog, we will set out the legal entities and operational frameworks that are relevant to 3AC operations worldwide, as well as providing professional background details about Mr Davies and Mr Zhu, and an overview of the types of financial and crypto investments that were historically made by 3AC. In the next blogs, this operational framework will then be used to enable readers to understand how matters will progress for all 3AC entities in the future.

About 3AC

3AC is a hedge fund firm that was said to have been established in May 2012 with a focus on providing superior risk-adjusted returns to investors (Davies 2014). This date was confirmed by Mr Davies in a face-to-face interview (Davies 2014, 0.33). It has a diverse operational history spread across multiple entities. The ‘Three Arrows Fund, LP’ was a limited partnership that was incorporated on 23 April 2012 in the US state of Delaware (File Number: 5143700; Service Address: 1013 Centre Road Suite 403-B, Wilmington, Delaware, 19805). According to public registration statements filed with the ‘U.S. Securities and Exchange Commission’ (SEC), the Three Arrows Fund, LP was run by ‘Three Arrows Capital, LLC’, a Limited Liability Company (LLC) incorporated on 17 April 2012 in Delaware (File Number: 5140797; same Service Address).

Both firms operated in San Francisco (Suite 606, 582 Market Street, 94104, California). However, ‘Three Arrows Capital Pte. Ltd.’ (3AC Singapore), is a firm that was incorporated in Singapore, with physical headquarters located in the Central Region, Singapore (7 Temasek Boulevard #21-04, Suntec Tower One, 038987). 3AC Singapore was an exempt private company limited by shares that was incorporated on 30 January 2013 (Registration Unique Entity Number: 201302969M). As a financial services firm based in Singapore it was subject to regulation and supervision by the Monetary Authority of Singapore (MAS).

In August 2013 it was registered as a ‘Registered Fund Management Company’ (RFMC), which meant that it was only authorised to serve up to 30 qualified investors, and to manage assets of not more than 250 million Singapore Dollars (SGD) (approximately 150 million Pounds Sterling (GBP or £)). Its registered Chief Executive Officer was Su Zhu. The latest financial accounts filed by 3AC Singapore with the Accounting and Corporate Regulatory Authority in Singapore were dated 16 July 2021 for Financial Year ending 31 December 2020.

So, 3AC as a business essentially started its operations in San Francisco in the US. It then registered 3AC Singapore as a RFMC in Singapore and subsequently incorporated and registered 3AC BVI in the BVI. The involvement of the BVI as a jurisdiction, derives from the legal domicile of the underlying investment fund managed by 3AC. This shift in legal domicile from Singapore to the BVI occurred from 1 September 2021. This is why liquidation (insolvency) proceedings were subsequently commenced in the BVI and not Singapore.

These proceedings refer to the case of In re Three Arrows Capital Limited, Case No. BVIHCOM2022/0119 (27 June 2022) commenced in the Eastern Caribbean Supreme Court, High Court of Justice Virgin Islands (Commercial Division). Bankruptcy proceedings under Chapter 15 of the US Bankruptcy Code were commenced on 1 July 2022 in the Southern District of New York (3AC Bankruptcy Case 2022). Chapter 15 proceedings generally provide for recognition by a US court of an insolvency proceeding in a non-US jurisdiction, i.e., a BVI insolvency proceeding in this case (Hyman and Lee 2022).

It was asserted that the bankruptcy proceedings against 3AC were commenced in the US in order to protect 3AC assets by facilitating an orderly, value-maximising liquidation of 3AC’s assets for the benefit of all of its creditors (3AC Bankruptcy Case 2022, p. 3). Operationally, 3AC Singapore novated the management of its only investment fund to an offshore entity situated in the BVI on 1 September 2021 (MAS 2022). However, on 29 April 2022 3AC Singapore notified MAS of its intent to cease fund management activities in Singapore as of 6 May 2022 (MAS 2022).

Within the BVI, there were two currently regulated entities identified by the BVI Financial Services Commission, namely: (1) ‘Three Arrows Capital, Ltd’ (professional fund) (3AC BVI) (BVI Registration Number: 1710531; Legal Entity Identifier: 54930062QQQOHPBEVM34; Registered Address: PO Box 2283, ABM Chambers, Road Town, VG1110, BVI); and (2) ‘Three Arrows Fund, Ltd’ (professional fund). 3AC BVI was incorporated in May 2012, and it had three directors, namely Mr Zhu, Mr Davies, and Mr Mark James Dubois, a BVI resident (3AC Bankruptcy Case 2022, p. 5). 3AC Singapore was 3AC BVI’s parent and principal shareholder.     

Mr Zhu and Mr Davies

Mr Zhu attended the Phillips Academy (Andover, Massachusetts) and Columbia University (New York). He worked as a trader at Flow Traders for just over two years (January 2009 to February 2011), followed by a short stint (9 months) as a trader at Deutsche Bank (Hong Kong) (June 2011 to February 2012). Mr Davies attended the Phillips Academy (Andover, Massachusetts) and Columbia University (New York). Both studied maths and economics whilst at Columbia University. Prior to co-founding 3AC, Mr Davies worked as a derivatives trader on the exotic derivatives equity desk at Credit Suisse (Hong Kong) (2009 to 2012).

However, Mr Davies was only officially licensed by the Hong Kong Securities and Futures Commission as a representative of Credit Suisse (Hong Kong) Limited from 20 January 2010 to 19 May 2012 (automated trading services; dealing in futures contracts; dealing in securities), i.e., 2 years 4.5 months. This means that it would seem to be the case that both Mr Zhu and Mr Davies had each acquired less than three years of professional trading experience prior to setting up 3AC. It also means that at that time, neither Mr Zhu nor Mr Davies held any type of professional investment advisory experience advising investment firms and/or individual investors.

In fact, if Mr Zhu and Mr Davies had been actively looking for employment directly within a market-leading hedge fund at that time, there would have been very few recruitment firms that would have been willing to work with an individual that presented less than three years of experience working within the hedge fund industry. In short, based on these combined credentials, it would likely have been extremely difficult at such time for 3AC to attract external (non-family) investors willing to invest significant sums of capital in an investment fund run by investment managers with no established track record whatsoever.

3AC Investments

It is therefore likely that the fund started out its investments using either personal and/or family funds, and that it was initially run more along the lines of a private family office, rather than a fully-fledged hedge fund that operated with strict separation of finance, compliance, operations, and risk management functions within the firm. [3AC crypto firm operations will be discussed in the next blogs.] The 3AC hedge fund did not originally start out investing in cryptocurrencies. Rather, it started out by seeking to trade traditional currencies in emerging markets such as Brazil, China, India, and Korea (Davies 2014).

Firm trading also included the adoption of market neutral arbitrage strategies that focused on the Asian equity and fixed income markets, and in particular cross-border market fragmentation (Opalesque 2012; Davies 2014). The firm’s initial trading style was described as an alternative, opportunistic-focused fund that leveraged investment opportunities that arose because of volatility in emerging markets, e.g., elections, sanctions (Davies 2014). However, over time, it sought to expand its investment strategies by also covering investments in options, equities, and a range of cryptocurrencies.

These investments covered cryptocurrencies such as Bitcoin (BTC), Ethereum (ETH), and Solana (SOL), with the firm often taking large, highly public, long positions. For example, in June 2020, 3AC became the biggest investor in Grayscale Investments’ Grayscale Bitcoin Trust (GBTC) by purchasing around $200 million shares (n=6.55%) (Baker and Godbole 2020). In 2021, SEC filings made by 3AC confirmed that it had taken a $1.24 billion (36,969 BTC) position in GBTC (Chaparro (January) 2021).

The $1.2 billion investment represented approximately 39 million GBTC units in 2020 (Shubber and Oliver 2022). In 2021, 3AC also co-led a $230 million investment in the Avalanche (AVAX) public blockchain ecosystem. In February 2022, 3AC invested $200 million in Terra (LUNA) tokens (NG 2022; Ostroff 2022). The firm invested more widely in crypto technologies, as well as taking various equity stakes in crypto start-ups. These crypto investments covered inter alia investments in:

(1) GameFi (“play-to-earn”) firms and games (e.g., Axie Infinity, Crypto Raiders, Dropp, Imperium Empires, Nyan Heroes, Multiverse);

(2) Base Layer (Layer 1) blockchain applications (e.g., Kusama, Mina, NEAR, Polkadot);

(3) blockchain scaling solutions (e.g., StarkWare);

(4) decentralised applications (dApps);

(5) decentralised finance (DeFi) applications (e.g., Aave, Ardana, Balancer, Bonfida, Fireblocks, Futureswap, Multichain, Neon, Orca, Perpetual Protocol, Synapse, Tranchess, Woo);

(6) non-fungible tokens (NFTs); and

(7) crypto trading platforms (i.e., Deribit, BlockFi) (BlockFi 2020; Wan (February) 2020; Wan (July) 2020; Chaparro (March) 2021; Voell 2021).

However, owing to the highly volatile nature of crypto assets and cryptocurrencies, and valuation difficulties with respect to NFTs and other non-liquid crypto investments, it is difficult to provide highly precise values for the firm’s ongoing annual assets under management (AuM). [This difficulty will be analysed and discussed in the next blogs.] For example, the crypto analytics firm ‘Nansen’ estimated that in March 2022 3AC held around $10 billion in cryptoassets (Shen 2022). In June 2022 it was reported that the Net Asset Value (NAV) contained in the last public statement filed by 3AC Singapore was $18 billion (£14.9 billion) (Hern and Milmo 2022). Yet, the liquidators’ court filing showed that 3AC held just over $3 billion in assets as of April 2022 (Chipolina and Samson 2022).

To be continued.